What is an agreement for operation and management of real estate?
What is a real estate operating agreement? This is commonly defined in common speak as an Operating Agreement, or a company Operating Agreement. A real estate operating agreement is a document that describes the business relationship between the parties and an operating agreement also describes what each party has as far as interests in the subject property and also profits or losses. The operating agreement will also describe how you envision the real estate partnership dissolving. So a typical operating agreement would describe the obligations of the different parties and how capital is being contributed into the entity. It also describes if there is a bank account and who are the authorized signatories on the bank account. Who can sell , lease, or transfer property? It describes how decisions are made and at what dollar levels on how the company or entity is being formed and operated. The operating agreement is often included in the buying agreement or the purchase agreement for the property, and is subject (unless it is merged into the corporate formation) to the general rules of corporate formation.
Essential Elements of a Real Estate Operating Agreement
The foundation of any real estate operating agreement typically hinges on four key components: the property description, general provisions, power of attorney, and the list of other agreement attachments. Let’s break down each one.
Property Description
This section of the operating agreement details the property in question, providing specifics like the address, parcel number, street directions and a low-level overview of the property. The inclusion of general property information is done to ensure that there is little question over what property the agreement is referencing.
The description of the property may also include a map of the specific parcel. Such a map might indicate how much of the property is landlocked, how the property is configured and where the natural borders are. Identifying these visual aspects of the property in the operating agreement makes it far easier to determine issues like whether a parcel has been crossed or otherwise affected by floodplains or rivers.
General Provisions
General provisions for any real estate operating contract include:
Power of Attorney
More specific to real estate than with many other types of contracts, real estate operating agreements often provide the granting of power of attorney from one partner or partner to another for the buying and selling of the property in question. One owner, for example, may not even be located in the continent where the property is located and thus be unable to be in a position to buy or sell the property if he or she needs to be physically present for such arrangements. Having a second owner (or multiple owners) with power of attorney is a useful way to distribute the work around physical presence.
Agreement Attachments
The attachments to real estate operating agreements are important as they will often list and label the attachments on the agreement to which the partners are all mutually bound. Examples include:
The attachments to an operating agreement for a real estate investment group provide clear legal guidelines for partners to follow. It gives each partner an attachment to which he or she can refer in determining what his or her role is within the structure of the group, which is why it is crucial to make sure all attachments are present, accurate and current.
Stay tuned throughout this week for more information on real estate operating agreements.
Drafting and Other Legal Issues
The next step in establishing an operating agreement is the drafting of the document according to the agreed structure and provisions that have been outlined during meetings with all co-owners. Depending on the real estate holding or the complexities of the ownership structure, the document can range from several pages to many pages with a multitude of provisions. In addition to the basic framework, the agreement should address the economic aspects of the property ownership such as the method in which financing is obtained for the acquisition and throughout the ownership. Another factor in the document will be the source for ongoing operations and maintenance costs to the property and how that cost is shared among the co-owners. The agreement can also cover decision making and dispute resolution mechanisms that are used to manage differences among the co-owners. Share of profits and distributions can be addressed in significant detail in the provisions of the operating agreement.
It is imperative that the operating agreement is drafted in consultation with a legal professional that is experienced in these types of agreements. The cost of consultation can pay itself back in far premium to later having to defend a poorly drafted or structured operating agreement.
Why You Need a Real Estate Operating Agreement
Having a real estate operating agreement is beneficial for several reasons. For starters, it brings clarity to each partner’s role in the agreement. Everyone knows where he or she stands, and how his or her position might affect the other partners. Many partnerships dissolve simply because of a misunderstanding or miscommunication. If the details of an agreement are clearly laid out in an agreement, the chances of a misunderstanding are greatly reduced. Having a written agreement can also reduce the chances of internal conflict. It helps manage expectations and minimizes disappointment among the partners. A real estate operating agreement also provides legal protection for partners. Without an agreement, partners might flounder over who gets the profits when a partnership makes money. Having an agreement in place eliminates any need to argue, and provides a clear directive. Furthermore, having a legal agreement in place can help provide uniformity in the eyes of the law. Disputes can be handled in a timely and proper fashion, and done according to the agreement on hand. Lastly, having an agreement in place can help provide certainty for the future. While details may change over time, and an agreement may be altered if the need arises, having an agreement in the first place can ensure no partners are cut out unexpectedly.
Mistakes to Watch Out For
Many mistakes can be made when drafting and executing a real estate operating agreement. You can easily find yourself in the throes of a dispute due to carelessness or misunderstanding of the law . Some common pitfalls include:
Failing to account for all parties involved in the project, for example, the developer and architects involved in the project
Not being specific about how profits and losses will be shared, especially alongside varying investment levels
Not having a provision that triggers the buyout of one partner’s interest in the company
Failing to specify what vote of ownership is required to make certain decisions
Failing to account for a sale of shares, withdrawal or death of an owner
Failure to properly execute the agreement, even though everyone agrees to the deal, such as improperly signing the documents
Failing to include information about key business records, such as how they are kept and in what form
Retaining nonessential provisions
Including nonessential provisions if their absence would not be a significant problem
Assuming self-made provisions do not need to be documented
Being unclear about capitalization requirements
Failing to hold meetings in accordance with the operating agreement
Keeping poor books that don’t allow for proper operations
Assuming non-operating owners will be adequately informed of important issues
Failing to keep owners updated on how business is progressing
Not appointing officers and allowing them to act without any limits
Not providing accurate financial reports for partners
Paying for items outside the scope of a partner’s responsibilities
Not ensuring sufficient time is allowed for the partners to review all documents pertaining to the project or allowing especially short periods for review
Inadequately covering how disputes will be resolved
Using nonnative terms from other agreements and expecting them to mean the same вещь
Not preparing amendments in accordance with the proper procedure
Failing to make all relevant parties aware of their rights and obligations under the operating agreement
Examples and Case Studies
To better illustrate the value of an operating agreement, let’s examine a few more case studies.
Case Study 1:
Facts: A group of friends who just graduated from medical school decided to pool their resources together and open a general practice clinic. Each person put in $50,000 for their first location, which they found in a great part of town. This was the first time they had engaged in any sort of business together, and the owners didn’t think anything of it when they each put their signatures on the organizational forms at their local business licensing office.
Problem: A year later, the property owner wanted to raise the rent on the space where they opened the clinic, since demand was high for locations in that area. The owner asked for an increase from $5,000/month to $7,000/month. The Doctors disagreed, and asked to negotiate a more reasonable figure. They didn’t think the property owner had a strong argument for increasing the rent, since rents in that part of town were being capped by the city.
Resolution: The owner was not willing to negotiate, and the Clinic could not afford the new rent or operate at a loss. At this point, the clinic had already established a good following, but only had enough working capital to operate for a few months without the revenue necessary to keep the business going. The Doctors decided to have a meeting with an attorney who specialized in real estate and business ownership. They learned that the local rent control laws were an advantage for the owner, and that the owner was not able to raise the rent to the full extent of the law without having to negotiate with the clinic to determine a fair market rate based on use. The rent rate was not truly "capped" and the owner could explore non-monetary benefits as part of negotiations. The Clinic and the property owner came to an agreement to explore the value of leasehold improvements in exchange for keeping the rent rate at the old number of $5,000/month.
As this case study demonstrates, leasehold improvements can sometimes be valuable enough to warrant a landowner’s support and cooperation. In this case, however, the Clinic had the help of an attorney to navigate the complex real estate laws and employer-employee laws. The Doctors learned first-hand that a real estate operating agreement would have helped them avoid this stemming crisis at its root by providing them with the opportunity to plan ahead and negotiate fairly before it became a sore business relationship.
Case Study 2:
Facts: Several young professionals co-owned a hotel on a busy series of blocks in their downtown area. Most of the original founders of the hotel were still on board as the business grew and thrived. One of the founders had departed after a few years of business, leaving a 10% interest in the hands of his spouse.
Problem: A few years later, the hotel was expanding its real estate by purchasing the corner lot next to them. The problem was that several members of the hotel ownership were against it. They felt that alterations to property ownership in large real estate ventures are too risky to try something so big without an operating agreement. Theopophilus fined that he was in the minority, and that a majority vote was in favor of acquiring the new lot and building a large addition. Over the course of the next month, the dissenters became more and more hostile toward the current majority shareholders. Competing businesses began moving onto the neighboring block. The dissenters refused to contribute to the construction costs as a form of protest. An internal fight led to the dissenters kicking Theopophilius out of the business with no compensation. The dissenters succeeded in acquiring the new land and in successful development of it.
Resolution: At the end of the last quarter of the term, the business reported its lowest net profits yet. With fewer customers at their now very small hotel, Tenopophilus stopped by for a last-ditch effort to help out the failing business. He offered to make a $50,000 investment into the business in return for 15% ownership shares. The dissenters decide to reject his offer and to continue business as usual. Eventually, the company was evicted and no longer exists.
This case study illustrates what can happen when parties to a business ownership or operation make major decisions without an operating agreement to guide their process. In this case, what started as a misunderstanding spiraled out of control and lead to a badly-botched outcome.
Changes to the Agreement
The terms of a real estate operating agreement should not be considered static. Business conditions, priorities and relationships change over time, which can necessitate adjustments to key provisions. Furthermore, certain provisions may need to be revisited and updated periodically in order to reflect changing business needs. While updating those terms can be a relatively simple process, it is best conducted in the context of an orderly amendment process like the one described below.
The following process is a suggested procedure for initiation of changes to an operating agreement:
An Operating Agreement may be amended or revoked if the amendment or revocation is executed by all of the Members of the LLC and the amendment or revocation is included in the LLC’s long-term records as well as its short-term records. If the amendment or revocation is not executed by all Members, a Member may petition a Louisiana district court for an order authorizing the amendment or revocation.
Any proposed amendment or revocation of an Operating Agreement that is tendered for review and comment shall be given an opportunity to be reviewed by all other Members of an LLC before any revised amendment or revocation is deemed to be adopted . By tendering an amendment or revocation, such amendment or revocation offering party unconditionally waives the confidentiality of such amendment and recognizes that the contents of the amendment or revocation may be distributed to any other Member of the LLC due to the necessity that all Members have an opportunity to review same.
If the amendment or revocation derivative in whole or in part from a tendered amendment or revocation is not adopted prior to submission of the amendment or revocation derivative to the other Members of the LLC, then the amendment or revocation derivative shall be deemed to have been originally adopted in the same manner and to the same extent as the tendered amendment or revocation derivative from which it was derived. The Member submitting a derivative of a tendered amendment or revocation shall resubmit such amendment or revocation along with the derivative for review and comment under the above procedures.
This procedure would facilitate orderly updates and revisions that could help a business avoid costly misunderstandings and disagreements.
